The Securities and Exchange Commission (SEC) on Thursday approved two proposals submitted by the national securities exchanges and the Financial Industry Regulatory Authority (FINRA) that address failures that occurred during the “flash crash” on May 6, 2010.
One initiative establishes a “limit up-limit down” mechanism that prevents trades in individual exchange-listed stocks from occurring outside of a specified price band.
When implemented, the SEC says this new mechanism will replace the existing single-stock circuit breakers that the commission approved on a pilot basis after the flash crash, when the Dow Jones Industrial Average fell more than 600 points in about five minutes and then quickly rebounded.
The second initiative updates existing marketwide circuit breakers that when triggered, halt trading in all exchange-listed securities throughout the U.S. markets.
According to the SEC, the existing marketwide circuit breakers were adopted in October 1988 and have been triggered only once, in 1997. “The changes lower the percentage-decline threshold for triggering a marketwide trading halt and shorten the amount of time that trading is halted,” the SEC says.
The exchanges and FINRA will implement these changes by February 4, 2013. On Thursday, the commission approved both proposals for a one-year pilot period, during which the exchanges, FINRA, and the SEC will assess their operation and consider whether any modifications are appropriate.
“The initiatives we approved are the product of a significant effort to devise a sophisticated, yet workable and effective way to protect our markets from excessive volatility,” said SEC chairwoman Mary Schapiro, in a statement. “In today’s complex electronic markets, we need an automated and appropriately calibrated way to pause or limit trading if prices move too far too fast.”
According to the SEC, the two proposals will work as follows:
‘Limit Up-Limit Down’ Plan for Individual Securities
The “limit up-limit down” mechanism, established jointly by the exchanges and FINRA, prevents trades in individual listed equity securities from occurring outside of a specified price band, which would be set at a percentage level above and below the average price of the security over the immediately preceding five-minute period. For more liquid securities—those in the S&P 500 Index, Russell 1000 Index and certain exchange-traded products—the level will be 5%, and for other listed securities the level will be 10%. The percentages will be doubled during the opening and closing periods, and broader price bands will apply to securities priced $3 per share or less.
To accommodate more fundamental price moves, there would be a five-minute trading pause, similar to the pause triggered by the current circuit breakers, if trading is unable to occur within the price band for more than 15 seconds. Under the new plan all trading centers, including exchanges, automated trading venues and broker-dealers executing trades internally, must establish policies and procedures to prevent trades from occurring outside the applicable price bands, honor any trading pause and otherwise comply with the procedures set forth in the plan.
Updated Marketwide Circuit Breakers
The revised marketwide circuit breaker rules update the existing rules by:
- Reducing the market decline percentage thresholds needed to trigger a circuit breaker to 7%, 13% and 20% from the prior day’s closing price, rather than declines of 10%, 20% or 30%.
- Shortening the duration of trading halts that do not close the market for the day to 15 minutes, from 30, 60 or 120 minutes.
- Simplifying the structure of the circuit breakers so that there are only two relevant trigger time periods, those that occur before 3:25 p.m. and those that occur on or after 3:25 p.m. The two periods replace the current six-period structure.
- Using the broader S&P 500 Index, rather than the Dow, as the pricing reference to measure a market decline.
- Requiring the trigger thresholds to be recalculated daily rather than quarterly.
The marketwide circuit breakers were not triggered during the severe market disruption of May 6, 2010, which led the exchanges and FINRA, in consultation with SEC staff, to assess whether the circuit breakers needed to be updated in light of today’s market structure.